On Tuesday, American Airlines Group (NASDAQ:AAL) reported strong fourth-quarter earnings in which adjusted earnings per share of $0.59 beat the average analyst estimate of $0.55. Not surprisingly, American Airlines bulls are very excited about these results, as they show that the company is performing well as it enters the merger integration process with US Airways.
However, the company still has one big disadvantage in competing with Delta Air Lines (NYSE:DAL) and United Continental (NASDAQ:UAL) for airline industry dominance: Asia. United and Delta have both historically had larger presences on the continent.
Most people expect Asia to be one of the biggest growth engines of the global economy in the coming decades. As a result, it is critical for American Airlines to have a strong Asian route network in order to compete for corporate travel contracts. American is introducing new flights to Asia to narrow the gap with United and Delta, but its hub positioning is far from ideal. As a result, growth in Asia could weigh on American's unit revenue for quite some time.
American's Asia dilemma
In 2013, airlines that were heavily exposed to Asia flew into significant headwinds. The devaluation of the Japanese yen, rapid capacity growth in China, and slowing GDP growth led to lower unit revenue.
In the fourth quarter, United Airlines, the top carrier to Asia, stated that PRASM -- a common measure of unit revenue -- fell 5% on its trans-Pacific routes. That underperformance partially offset solid gains elsewhere, leading to a system-wide PRASM increase of 3.2%. A similar story played out at American, as trans-Pacific unit revenue fell 6%. However, since American has a much lower exposure to Asia, its system-wide PRASM grew 5%.
Given the ongoing unit revenue weakness in Asia, it's not a great time to add more capacity to the continent. On the other hand, American is in a dogfight with United and Delta for corporate traffic. United is taking every opportunity available to promote its position as the top carrier to Asia (and especially to China). Meanwhile, Delta is building a big international gateway in Seattle, from which it will serve the top five Asian business markets by mid-2014.
Recognizing the long-term importance of Asia, American Airlines will up its capacity to that end point later this year. Starting this summer, it plans to offer nonstop flights from Dallas-Fort Worth (its largest hub) to Shanghai and Hong Kong. This is part of a broader 9% increase in American's international capacity this year.
Growing in Asia is probably the right choice for American from a long-term perspective, but investors should recognize that these flights will probably be money losers initially. In many cases, it can take two to three years for new airline routes to reach profitability.
Additionally, American faces a longer-term disadvantage in Asia compared to United and Delta. In terms of geography and cultural ties to Asia, San Francisco and Seattle are the best-located gateways for trans-Pacific flights. However, United has solidified a dominant position in San Francisco and Delta is rapidly ensconcing itself in Seattle as the dominant international carrier.
None of American's hubs are nearly as good for connecting traffic to Asia. Dallas-Fort Worth is one of the largest airline hubs in the world, but it is about 1,500 miles further from Asia than San Francisco and Seattle (roughly three hours of flying time). It is also an inconvenient transfer point for most U.S.-origin cities.
American's Chicago and Los Angeles hubs are slightly better positioned geographically, but the airline has fewer flights to those airports and it faces strong competition in both cities, particularly from United.
American Airlines has gotten off to a great start following its merger with US Airways, but the company is going to need to invest a lot of money in the next decade to build up its route network in Asia. Doing so is critical for grabbing corporate travel share from United and Delta (particularly the former, which has the biggest presence in Asia today).
However, even as American grows in Asia, it is likely to remain in third place there for the foreseeable future. United and Delta have already seized the two best trans-Pacific gateways in the U.S. None of American's hubs are as well positioned for serving Asia, and that will make it less profitable on the continent in the long run.
While American is the laggard in Asia among the top three U.S. airlines, it is by far the top airline to Latin America, which is another long-term growth market. American's strength there could make up for its weaker position in Asia. Only time will tell.